The evolution of Index Investing: From market Cap to Factor-Based ETFs
For years, passive investing in India only meant one thing, i.e. tracking a standard market-capitalisation-weighted index like the Nifty 50 or the BSE Sensex. In these traditional funds, the largest companies carry the highest weights.
However, with the maturation of the Indian capital markets, a new form of passive investing has come up that is challenging this, bridging the gap between active stock picking and traditional indexing, known as Factor-Based ETFs. In this blog, we will discuss Factor-Based ETFs in detail.
What are Factor-Based ETFs?
Traditional index funds are operated based on the market capitalisation-weighted approach, whereby companies with a higher market value have a bigger impact on the index’s performance. In contrast, Factor-Based ETFs are widely categorised as Smart Beta ETFs that follow a rules-based strategy which selects and weighs stocks based on specific financial metrics or factors rather than just their market size.
For example, the Nifty 500 Momentum 50 ETF (Exchange Traded Fund) is based on the Nifty 500 Momentum 50 Index. It seeks to generate returns as per the performance of 50 stocks selected from the Nifty 500 index based on momentum.
These factors are well-researched historical drivers of return. The most prominent factors utilised in the Indian market are as follows:
- Value: This strategy is based on investing in undervalued stocks based on metrics, such as Price to Earnings (P/E) or Price to Book (P/B) ratios, and dividend yield. It is often suitable for long-term investors.
- Momentum: Momentum funds invest in stocks that have performed well in terms of price movement over the recent past. While strategy is suitable for trending markets.
- Low volatility: This factor invests in stocks that have lower price fluctuations to minimise downside risk. It is favoured by conservative investors.
- Quality: Quality-focused funds invest in companies that have strong balance sheets, high Return on Equity (ROE), low debt and stable earnings. These companies tend to do well during different market cycles.
- Equal weighting: This strategy gives every stock in the index equal weight, which means no single stock or sector can have a dominant stake in the portfolio, and hence, reduces the risk of concentration.
- Fundamental weighting: These funds use fundamental metrics such as earnings, revenue, book value or dividends, rather than market capitalisation, to weight stocks.
Benefits of investing in Factor-Based ETFs
The Factor-Based funds provide a compelling proposition by combining the benefits of passive investing (transparent rules, lower costs) with the benefits of active investing (strategic stock selection). Some of the advantages of Factor-Based ETFs include:
- Potential for risk-adjusted returns: These ETFs provide above-market returns or lower risk by capturing proven investment factors.
- Enhanced diversification: Strategies, such as equal-weighting, employed in Factor-Based ETFs help ensure that no single stock or sector has too much impact on the portfolio, reducing the risk of concentration.
- Transparency and discipline: The rule-based nature of Factor-Based ETFs means the strategy is clearly published, providing investors with transparency on the process of stock selection and weighting.
The wrap-up
In India, Factor-Based ETFs are relatively new, and most of the options have been launched only in the last 5-7 years, so there’s a limited track record to judge their performance across the full market cycles.
However, Factor-Based ETFs are an exciting innovation addressing a gap between traditional index investing and active fund management, and provide a smarter option for diversification and potentially outperforming traditional indices.
